Come Hell or High Water

Governor Waller suggests two significant changes to the Fed’s QT framework that effectively removes all obstacles to an extended QT. First, Waller suggests that the $2t in RRP balances should be consolidated with bank reserves when thinking of bank liquidity levels. This indicates that the Fed would be comfortable with bank reserve levels dropping below the roughly estimated $2.5t minimum level. Second, Waller appears to be open to maintaining QT even if policy rates are cut. This would reverse longstanding Fed dogma where both the policy rate and balance sheet must express the same stance of monetary policy. This post reviews these two developments and suggests that they represent an effort to re-tighten financial conditions by steepening the curve.

RRP Balances Are Reserves

The Fed appears to have redefined their criteria for minimum banking sector liquidity in a way that enables QT to continue for years. QT withdraws liquidity out of the financial system, but in ways that the Fed is not able to control. The liquidity can come out of the banking sector (bank reserves), or it can come out of the RRP (RRP balances). So far, QT has largely drained liquidity out of the banking sector. This presents a problem to the Fed, who seeks to continue QT and also keep bank reserves levels above ~$2.5t. Reserve levels are around $3t today and on track to fall below the estimated minimal level by end 2023.

Waller now suggests that he views RRP balances to be fungible to bank reserves. He suggests banks who need liquidity can simply raise deposit rates to attract money out of the RRP. Under this framework, banking sector liquidity for QT purposes is over $5t ($3t reserves plus $2t RRP balances). Waller also suggests that QT would be tapered when banking sector liquidity is around 10% of GDP. With the actual QT run rate around $75b per month, QT could continue for three more years under this change.

Note that this change will likely have very limited impact on money markets, as the actual liquidity needs by banks is likely far lower than the Fed’s estimate.

Thou Must Be Consistent

Waller indicates that he is open to conducting QT while also cutting rates. A longstanding tenant of Fed dogma has been that the policy rate and balance sheet policy must express the same stance of monetary policy. This means QE can only occur when the Fed is in rate cutting mode, and QT can only occur when the Fed is in hiking mode. This constraint is self-imposed and appears to stem from the difficulty in communicating what would appear to be contradicting signals – the Fed both stepping on the gas and brakes at the same time.

The dogma of consistency likely contributed to a policy error in 2021 and may need relaxing. Former Fed Governor Quarles has suggested that the constraint kept the Fed from hiking rates in 2021 when it was obvious inflation was becoming a problem. In the same way, the need for consistency would keep the balance sheet much larger than needed should the Fed decide to cut rates in the coming months. The BOE has already demonstrated through its emergency purchases that it is possible to separate the balance sheet and policy rate. The Fed should also be able to do the same.

Re-Steepening

The Fed’s new guidance is likely an attempt to retighten financial conditions amidst the recent bout of rapid loosening. Market participants appear to believe that rate cuts are imminent, which in turn have led to lower mortgage rates, a weaker dollar and higher asset prices. This increases the probability of a second bout of inflation, an issue in the 1970s that the Fed is keen to avoid. In the absence of firm forward guidance, the Fed’s obvious tool to retighten financial conditions would be through its balance sheet.

In practice, the policy rate and balance sheet policy likely operate on different channels with different impacts on the real and financial economy. The experience across countries over the past decade suggests QE has limited impact on the real economy, but significant impact on the financial economy. Should QT continue amidst rate cuts and low policy rates, we may find out if the reverse is also true. That would be precisely the type of tightening the Fed is looking for.